chase or sale balances in excess of 700 shares. In approximately 5 percent of their stock days they posted net purchase or sale balances in excess of 2,000 shares, and these balances ranged up to 64,000 shares.5 509 In broad terms it is possible to explain the rather consistent sale balances of members' trading from off the floor by reference to shares obtained off the exchange via stock splits, stock dividends, new issues, arbitrage, et cetera. It is impossible, however, to pinpoint the primary source of the "excess" shares, or to weigh the relative importance of the various possible sources, due to a virtual absence of data.510 Until data are available indicating the extent of member trading from off the floor for various purposes (investment, speculation, arbitrage, offsets of positions by regional specialists, et cetera), the source of the unusual sale balances characterizing such trading, and the degree of its concentration in particular stocks, no conclusions may be reached as to the significance of this type of trading. Some thought should be given, therefore, to the propriety of expanding the present reporting requirements for members off floor. 5. SUMMARY, CONCLUSIONS, AND RECOMMENDATIONS Trading by NYSE members on the exchange but from off the floor accounts for approximately 5 percent of total exchange purchases and sales, but on occasion accounts for more than 50 percent of all purchases or sales in a given stock over a given day or week. Generally such trading is characterized by a tendency to favor stocks and stock days of high volume; and by a rather consistent pattern showing significantly more sales than purchases. The sources of the shares sold on the exchange in excess of those purchased are generally considered to be stock splits or dividends or arbitrage purchases in other markets, but data have not been obtained to confirm these assumptions. Similarly, the extent to which member off-floor trading represents investment, speculation, arbitrage activity or other functions has never been ascertained. Until such data are available, no conclusions as to the significance of such trading may be reached. The Special Study concludes and recommends: 1. The purpose, nature, and significance of trading by members from off the floor remain concealed in the aggregate data reported by such members to the NYSE each week. Because this trading on occasion accounts for a large percent of total trading in individual stocks, and may therefore have a substantial impact on the trading in such stocks, the propriety of expanding the present reporting requirements of members trading from off the floor should be considered by the NYSE and the Commission. H. SHORT SELLING 1. INTRODUCTION A short sale is the sale of stock which the seller does not own or which he owns but does not deliver. In order to make delivery, he 500 This sale balance was registered in Rhodesian Selection Trust, Ltd., on Mar. 22, 1961, and was probably due to foreign arbitrage activity. 810 The NYSE did send a form to a sample of its members in the summer of 1962 in an effort to ascertain the sources of these sales, but felt that the results were not reliable. The Exchange has indicated that the study will be continued. borrows the stock, which at some later time he returns to the lender, ordinarily obtaining it by purchase in the open market. There is only partial accuracy to the popular conception of the short seller as a free-wheeling speculator who anticipates a market decline so that he will be able to buy, or "cover," at a lower price, realizing as his profit the difference between the sale price and the subsequent purchase price. Speculation is but one of the motivations which may lead to short selling. Among the nonspeculative kinds of short selling are the so-called technical short sales-e.g., by arbitragers, specialists and odd-lot dealers-the hedging short sale, the short sale for tax purposes and the short sale "against the box"; all of these are explained below, and some are analyzed in detail subsequently. In 1934, the Senate Banking and Currency Committee found that "few subjects relating to exchange practices have been characterized by greater differences of opinion than that of short selling," 511 and the matter was one of the central issues in controversy during the congressional scrutiny of exchanges and their practices which led to enactment of the Securities Exchange Act of 1934. Argument about the utility and impact of short selling tends to be renewed after each major downward plunge of security prices. In part, the objections to short selling seem grounded in a vague attitude that it is simply gambling, of no economic value. More particularly, it has been attacked with the claim that its banishment would remove a market force which serves only to accentuate the violence of periodic price swings. The crux of the argument in defense of short selling is that it helps to maintain an orderly market and to stabilize price fluctuations. The classic theory has held that short selling occurs when the market advances, thereby acting as a brake to the rise, and conversely, that the resulting covering transactions, which represent the only compulsory buying power in the market, take place as prices decline and thus act as a cushion breaking the force of the decline. Under section 10(a) of the Exchange Act, Congress granted the Commission full power to regulate short selling.512 The purpose of this part of chapter VI is to examine the rules regulating the practice and to evaluate some of the effects that short selling has on the market. Short selling also takes place in the over-the-counter markets,513 but the subject is considered in the present chapter because the available data concerns short selling on the major exchanges. a. Method and scope of study Short selling has been the subject of various prior analyses under different market conditions and regulatory requirements. The Special Study has made use of this informtion as well as of data filed with the Commission by the New York Stock Exchange on a continuing basis, and of members' reports on file with that exchange. To supplement these data, the Special Study requested additional statistics on short selling for limited periods. Detailed information was obtained covering individual transactions by members and by a S. Rept. 1455, "Stock Exchange Practices," Senate Committee on Banking and Currency, 73d Cong., 2d sess., p. 50 (1934.) 612 An outright ban on short selling by "insiders" of issues of listed securities was enacted, with limited exceptions. See exchange Act, sec. 16(c). 13 See app. VII-A for some data on short selling in the over-the-counter market. Public customers' over-the-counter short sales of NYSE-listed securities appears to be negligible; see ch. VIII.D. substantial sample of nonmembers for the market break period of May 28, 29, and 31, 1962, in eight stocks actively traded on the New York Stock Exchange; summary data on a daily basis were obtained for 14 selected days prior to, and 2 selected days subsequent to, the market break period.5 514 Since short sales exempted from the Commission's short selling rules, such as arbitrage transactions, are included as "long" sales in all trading reports, no record of exempt short sales is available in any form other than individual accounts kept by brokers and dealers. In an attempt to evaluate the use of the exemptions, offices of nine firms were visited and their records examined, and arbitrage accounts of three firms were requested and examined for the period of the market break. The study includes analyses of the sources of short selling by categories of NYSE members and nonmembers, of the types of securities in which short selling has been most prominent, and of the relationships between changes in short positions and subsequent price trends. The study also provides an evaluation of the extent and significance of short selling in the eight selected stocks. Additionally, there are limited discussions of short sales exempted under Commission rules. No information was obtained on short covering transactions and only indirect reference to this aspect of short selling is made in the present report. b. The mechanics of short selling The usual speculative short sale on an exchange involves the following steps: 1. A customer who expects that a stock will decline from its present price, but does not own any shares of it, instructs his broker to sell the stock short on the exchange. 2. The sale is made as a regular sale, subject to SEC and exchange rules discussed in section 1.d, below. 3. The short seller's broker borrows shares and makes delivery to the buyer. The stock may be borrowed from the broker's customers' margin accounts 515 or the broker's own accounts, or from other brokers.516 In the last case, cash equal to the current value of the securities must be deposited with the lending broker; this deposit may be increased or reduced as the brokers "mark to the market" in line with significant movements in the stock's price. Whatever the source of the stock, such loans ordinarly involve neither cash compensation to the lender nor interest to the borrower. 4. Except for the normal costs of execution, there is no fee attached to executing a short sale. The short seller must deposit in his margin account with his broker an amount satisfying the required margin. Of course if the price of the stock should rise to the point at which the exchange's margin maintenance requirement applies, the short seller will have to deposit more cash or securities or close out his short position. If he is willing to make such further deposit (or if none is needed) and willing to cover any dividends or other distributions on 514 For a more detalled discussion of these data, see ch. XIII. 615 The borrowing and lending activities of odd-lot dealer firms, for example, are discussed in pt. E, above. 816 See ch. III.D. the stock, the short position normally can be maintained indefinitely, but, it is believed, is usually covered relatively soon. 5. At some later date, when the price of the stock has fallen or when the short seller has for some reason decided to take a loss, he buys in the market to cover his short sale. The short selling mechanism would break down but for the availability of stock for borrowing in order to make delivery. At one time brokers interested in making such arrangements congregated in a socalled "loan crowd" at a designated place on the floor of the Exchange. Among the principal lenders were large corporations, investment funds, and even banks who were represented by their own brokers. Sometimes the loans were made at premiums providing the lenders with extra income. Today a premium is extremely rare; it may be charged if a "short squeeze" develops in the stock, as it might in a stock with a large short interest and a limited floating supply of shares. c. Types of and reasons for short selling (1) Speculative short selling As already noted, to speculate on the short side is to sell stock, in the expectation that the stock's price will fall and make possible a profitable covering purchase. In order to get at the short interest resulting from speculative sales, a study was conducted in June 1947 by the New York Stock Exchange at the request of the Commission. For this purpose a breakdown was requested of the short interest outstanding for members and nonmembers, showing the totals in each class of short position, such as "against the box," arbitrage, and hedges. When these categories were counted, the speculative short interest was found to be about two-thirds of the total. Current data are not available but the one-time survey serves to indicate that since some of the short interest represents technical short sales such as arbitrage transactions or "sales against the box,” not all of the short interest represents compulsory buying power. (2) Technical short sales—facilitating operations in the market (a) The specialist.-The specialist's function on the stock exchange is to maintain price continuity and to minimize the effects of temporary disparity between supply and demand. More simply, his duty is to maintain an orderly market.517 At times, he does this by using the short sale to supply stock. (b) Odd-lot dealers.-The odd-lot dealer sells to his customer, or buys from him, amounts of stock which are less than the unit of trading on the exchanges.518 However, he must deal in regular units, i.e., round lots, when buying and selling on the exchange. The odd-lot dealer, therefore, may sell round lots short either to anticipate or to offset odd-lot orders of his customers. When the Commission adopted its first short selling rules in 1938,519 it exempted short sales in odd lots as well as certain short sales by the odd-lot dealers because of the "undue burden and inconvenience which a short-selling restriction would place on the odd-lot machinery of the securities exchanges." ." 520 However, several exchanges, notably the 517 See pt. D of this chapter. 518 See pt. E of this chapter. 619 See subsec. d(2), below. 8:20 Securities Exchange Act release No. 1548 (Jan. 24, 1938). New York Stock Exchange, the American Stock Exchange, and the Midwest Stock Exchange, have adopted regulations making the Commission's short selling rules applicable to sales of odd lots, except those of odd-lot dealers. (c) Arbitrage.-Arbitrage, in essence, is a series of transactions whereby a trader takes advantage of a price difference between equivalent securities. The difference in price may arise because the identical security is being traded in two different markets, or because exchangeable securities are being sold. Thus, a stock might be selling at a lower price on the New York Stock Exchange than on the Pacific Coast Stock Exchange or in London; the arbitrager would buy in New York, and at the same time sell short in one of the other markets. Arbitrage involving different forms of securities may occur, for example, when a security which is convertible into the issuer's common stock is available for less than the current value of the shares into which it is convertible, or when an exchange of securities is being effected pursuant to a corporate reorganization or merger. In these cases, the arbitrager sells the shares short, buys the convertible or exchangeable securities, and later turns those into common stock to make delivery. One firm spoke of arbitrage as follows: The secret of successful arbitrage [is] turnover. Because of fractional differences per 100 share unit between the purchase and sale and the expenses of operation which include commission, taxes, and other incidental expenses, there must be a very large volume turnover to make a sizable profit and there is always the risk of a loss. (3) Hedging The hedging short sale is used by a security holder who fears a price decline but wants to continue to hold his securities. For example, it may be that the securities are inactive and he believes he cannot sell at a good price. Rather than disposing of his own securities, he will sell short approximately the same dollar value of the stock of a "market leader" or of another company in the same industry. If the market goes down, he covers the short sale at the lower price and has succeeded in balancing the loss taken on the securities he held throughout. If the market rises, he takes the loss on his short sale, but may be compensated for it by a rise in the stock he wanted to hold. (4) Taxation Most of the advantages of the short sale for tax purposes were eliminated by revisions in the tax code in the early 1950's. Nevertheless, the short sale can still be used to preserve a gain without realizing the income until the following year. Although this type of short selling may tend to increase near the end of the year, the available statistics are not of a nature either to confirm or to deny the supposition. Trading such as this, in which the seller owns the particular stock sold short, is called selling "against the box"; some argue that it is not short selling at all. Selling against the box also may be resorted to, for example, when the seller cannot conveniently get the securities from his safe deposit box in time for delivery, or for reasons of secrecy. Also, though technical, short positions may arise particularly in the case of an underwriter of stock or bond issues. The underwriter |